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Correlation funds pitched following hedging woes

Mark Pengelly

02 Nov 2007

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From July 2 to July 30, spreads on the five-year on-the-run iTraxx Europe Index ballooned by 176% to 68 basis points. As credit spreads widened, correlations across CDS IndexCo’s CDX North America and iTraxx Europe credit derivatives indexes increased, according to research from Barclays Capital.

Such moves have thrown some correlation hedging strategies awry. The situation has been widely compared to the correlation crisis of 2005, when the downgrades of General Motors and Ford caught some dealers off-guard.

“Much like the volatility in the correlation market in May 2005, the volatility in recent months in 2007 creates a significant opportunity,” said Bryce Markus, New York-based managing principal at hedge fund Blue Mountain Capital Management.

During October, Blue Mountain launched an $80 million closed-end fund called Correlation Relative Value II. It has an initial lock-up period of around six years and will invest in assets such as cash and synthetic collateralised debt obligation (CDO) tranches, collateralised loan obligations and the CDX credit and LCDX loan derivatives indexes. The creation of the new fund follows the success of the firm’s Correlation Relative Value I fund, which was launched shortly after the 2005 crisis.

London-based Credaris Portfolio Management is also building on a correlation strategy it began pursuing after the fallout of 2005. It is seeking external investor interest in its Credaris Correlation Fund, which it hopes will commence trading by November with €150 million ($216 million) in capital. Credaris has a team of five working on the strategy, which will focus on standardised and bespoke synthetic CDO tranches.

Gennaro Pucci, the fund’s portfolio manager, said that in May 2005 idiosyncratic risk pushed value to the bottom end of the capital structure. “In July 2007, we had exactly the reverse: more systemic risk, which pushed value toward the upper end of the capital structure.”

The exodus from the credit markets of conduits and structured investment vehicles, which are typically buyers of highly rated structured credit assets, has helped depress demand for the top tier of the capital structure. In the immediate future, Pucci suggested he expected flagging demand in senior structured credit to continue.

“We believe that what we have seen in the CDO market in the past couple of years – buying pressure from conduits and others – is probably going to be off-market for a while.”